Tsunami Warning For Banks

An economic tsunami warning is being sounded but are bank investors listening?

Jim Rickards, Senior Managing Director of Market Intelligence, and Chris Whalen, Co-Founder and Managing Director of Institutional Risk Analytics tell me the sputtering real estate industry is brewing a cocktail of economic disaster and bank investors need to be on high alert.

JR: There is a perfect storm brewing for bank stocks and bank earnings and there are three components to the storm.

Vector number one: strategic foreclosures. Now the idea is spreading with people who have homes that are down 50% or more and have no equity are strategiclly walking away from their homes. These homeowners have jobs. They are deciding to rent before their credit rating goes down and abandoning their monthly mortgage payments.

Second vector are the putbacks. There is a lot of toxic waste and now buyers are trying to scrub their mortgages to see if there is a defect in the loan file.

I have never seen a file without a defect. There are so many non performing loans that buyers can cherry pick all their loans — keep the ones they want to and put back the mortgages with the defects. Banks are fighting them, but this is a huge tsunami that will impact bank earnings on an on going basis.

The third vector are the legal defects themselves in the foreclosure process.

Put all this together and I would see an impact in late first quarter 2011. This is not going to affect the banks immediately. The banks are resisting this, They are not making provisions for this, they're putting up their defenses.

Its kind of a juggernaut that's going to drag them down and by the end of the first quarter in 2011 when they might have to own up to some of this stuff. One reason why this is coming on stream is the statue of limitations. Its been two years since the meltdown.

LL: Chris, when are you expecting the storm to hit?

CW: When the too big to fail banks can no longer fudge the cost of restructuring their real estate exposures, on and off balance sheet. Q3 earnings may be the catalyst

LL: What banks are most exposed to this tsunami?

CW: Bank of America, Wells Fargo, JPMorgan, Citigroup among the top four. GMAC. Why do we still refer to the ugly girls — Bank of America, JPMorgan and Wells Fargo in particular — as zombies? Because the avalanche of foreclosures and claims against the too-big-too-fail banks has not even crested.

LL: Where should investors be putting their money?

CW: Investors should be looking at liquid, government-covered vehicles to preserve principal through deflation, then stocks when the inflation updraft begins.

LL: Have you quantified the risk that is looming?

CW: Yes, we still have a couple trillion dollars worth of losses. If the predictions of Goodman and other analysts are correct, the future losses to the U.S. banking industry and investors in ABS will be staggering. Something like one third of all banking assets are related to real estate — more if you include securitizations and other OBS vehicles. These predictions suggest a further decline of bank revenue and earnings that exceed the dire forecasts of some analysts.

JR: 2011 will be the year of reckoning.

Little by little as the banks are examined and these write downs are forced banks may be forced to write down other assets that effect each other. More things will go on the market at lower prices.

By this time next year we'll be looking at a crisis in mortgage finance and asset values in both residential and commercial that will appear to be as severe as what we went through in 2008.

LL: Is there anything that can be done to prevent it?

JR: What the government would want to do is quantative easing. The Fed is desperate to get asset values up. They want inflation. But the natural state of affairs is deflation which is what you get in a depression. And we're in a depression. It started in 2007, and its going to run until 2012, 2013. It may be longer depending on policy.

In a depression you can have rallies. You can have declining unemployment for periods of time. You can have a little bit of growth. But what you don't do is, you don't escape the pull of deflation. You don't escape the decline in asset values, and that slow grind going downwards.

You never get away from it. The fed has tried quantative easing but it hasn't been very successful.

LL: Why do you think we are in a depression?

JR: This is not an income problem; its a balance sheet problem. We are not in a liquidity crisis. We are in a solvency crisis. Now those two things can affect each other. If liquidity gets worse it affects solvency and vice versa. It is really important to understand where the problem began.

Unlike all the other recessions in the post World War Two period, which were all liquidity driven, and therefore fixable with injections of liquidity and more or less short term in nature, this one is solvency driven, and you do have to go back to the 1930's, and the problem with that is its never over until asset prices reach their natural level meaning they reach a bottom. And all of these people who have talked about a "V" shaped recovery, they don't really have the courage of their convictions because they don't want to see the bottom.

What happened was we were on the down slope of the "V" and we were going down very fast and hard. But we never hit the bottom because the Fed intervened and truncated the collapse. It gave us a flat line and that's where we are now. You're not going to get the up leg of the "V". You're not going to get that expansion until you hit bottom first. So we are not going to get any growth.

Best case is Japan of the 90's. Ten years of no growth. Worse case is we let the forces play out and we find a bottom. Good news with that is then you can start to grow. But the bottom will be ugly.

LL: Can anything be done to soften the storm Chris?

CW: Restructuring to re-liquefy banks and turn public sentiment. We can gain enormous lift from purposeful, direct action. And FDIC, fed now have the power to act.

LL: How many banks to expect to fail next year because of this?

CW: The better question is how we will deal with the process of restructuring. My view is that the government/FDIC can act as receiver in a government led restructuring of top-four banks. It is time for PIMCO, BlackRock and their bond holder clients to contribute to the restructuring process.

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